Jonathan Adler
Associate Director, Center for Business Law & Regulation, Case Western Reserve University

Thank you, Mr. Chairman and members of this Committee, for the invitation to testify on S. 1772, the Gas Petroleum Improvement and Community Empowerment Act. My name is Jonathan H. Adler, and I am an associate professor of law and associate director of the Center for Business Law and Regulation at the Case Western Reserve University School of Law, where I teach several courses in environmental law. This fall, I am a visiting associate professor at George Mason University School of Law, where I am teaching environmental and administrative law.

For the past fifteen years I have researched and analyzed federal regulatory policies, with a particular focus on environmental regulations. Portions of my research and scholarship have focused extensively on the ways well-intentioned environmental regulations may have unforeseen and unfortunate consequences, on the impact of environmental regulations on the energy sector, and on the balance between federal and state authority in environmental protection. I appreciate the opportunity to share my views on S. 1772, particularly as it relates to my ongoing research.

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Key provisions of S. 1772 seek to expand domestic refining capacity. This is an important goal, as domestic refining capacity is one of the many factors that can influence the cost and volatility of retail gasoline prices. While there have been recent increases in domestic refinery capacity, these increases have not kept pace with demand growth, and this trend is likely to continue. In recent years the lion’s share of investment in the refining sector has gone to meet various environmental and other regulatory mandates, not to increasing refining capacity. Moreover, while some of the gap between domestic demand and domestic refining capacity can be made up through imports (which now account for approximately 10 percent of domestic consumption), strong and ever increasing global demand will put further upward pressure on prices. In addition, with the proliferation of additional fuel content and emission requirements, there is reason to question whether foreign refiners will continue to make gasoline for the U.S. market.

Markets respond naturally to price fluctuations when they are able to do so. Higher prices signal to investors that there are potential profit-making opportunities. Where markets are free to operate, price increases should spur investments to increase supply (and should encourage consumers to reduce consumption). Government interventions in commodity markets, whether direct or indirect, tend to short-circuit the market’s natural feedback mechanisms. This does not mean that such interventions are unwise or unjustified, but it does mean that they should be taken with care. Above all else, new policy measures should be careful not to cause further disruptions in the marketplace that could short-circuit the effective operation of supply and demand.

Few markets today are fully free of government interference. Energy markets are a case in point. Myriad government policies at the federal and state level affect the discovery production, transportation, processing, distribution, and sale of all forms of energy. These interventions, particularly in the aggregate, retard the market’s ability to respond to changes in supply and demand and increase price volatility, as well as the likelihood of temporary supply disruptions.

For these reasons, it is important that federal responses to recent gasoline price increases seek to remove or ameliorate regulatory barriers to efficient market responses to current and prospective price changes. Such strategies are more sensible than chasing after alleged “price gouging” or adopting new mandates or subsidies for energy efficiency, as such market-enhancing strategies can unleash the market’s natural tendency to equilibrate supply and demand. Alternative strategies, however well intentioned, tend to impose costs on consumers in excess of their putative benefits.

While there is much popular discussion about oil industry profits and current margins within the refining sector, it is worth placing these figures in perspective. By historical measures, profit margins in the refining sector have been lower than in other segments of the oil and gas industry, and lower than the average for S&P 500 companies. Moreover, the greater the profit margin in the refining sector, the more rapidly the marketplace will adjust to meet increased demand for fuel products of various types. Insofar as this Committee is concerned that some suppliers are able to charge unduly high prices for gasoline, and reap “excessive” profits, the best policy response is to take measures that will ensure such firms are exposed to competition.

From this perspective, Titles II and IV of S. 1772, the Gas Petroleum Improvement and Community Empowerment Act, are most welcome. Rather than seeking to override or second-guess private market decisions, the bill seeks to minimize the extent to which desired environmental protections impede the efficient functioning of energy markets. Rather than imposing federal mandates on state governments or trampling upon local communities, these provisions seek to provide greater opportunities for increases in refining capacity consistent with state and local preferences. While this legislation is not a panacea for current gas price concerns, it is a modest, welcome step toward addressing those concerns.

Refinery Permitting Process

There is a clear need for increased refining capacity in this country. While existing domestic refining capacity is adequate to meet current demands, it is unable to respond to surges in demand or disruptions in supply. The relative lack of refining capacity both supports higher prices and increases price volatility because it is more difficult to respond to regional changes in demand. Moreover, the steady increase in global demand for refined petroleum products makes it more expensive to meet increased domestic demand through imports.

Insofar as regulations, including permit requirements, add to the financial cost of and potential delay in constructing or expanding a refining facility, they will reduce the likelihood that such investments will take place. Insofar as regulatory requirements create uncertainty, this will further discourage such investments on the margin. Streamlining the permit process, as proposed in S. 1772, is an effective way to reduce the cost and uncertainty involved with environmental compliance without sacrificing environmental protection or public participation. As the experiences of many state environmental agencies have shown, it is possible to streamline the permitting process without sacrificing environmental protection, through the adoption of coordinated, simultaneous reviews of various permitting requirements across environmental media, deadlines for permitting decisions, and other innovations.

Unlike some other proposals to streamline the permitting process for refinery construction and expansion, the provisions in S. 1772 do not displace state authority or trample upon local communities. As the text of the legislation makes clear, the relevant provisions are only to be invoked at a State’s request. Equally important, nothing in S. 1772 alters the substantive environmental requirements of federal or state law. While the legislation establishes clear deadlines for permit review, 270 days is an ample amount of time for the review of a completed permit application for the construction of a new refinery, and 90 days should be sufficient to review permits for the expansion of facilities that already exist. If a federal agency is to be involved in consolidating and streamlining the state and federal permitting processes for refinery construction or expansion, it should be the Environmental Protection Agency, as the EPA is already responsible for oversight of much state permitting and enforcement under existing federal environmental laws. Such expertise is important if the permitting process is to be accelerated without compromising environmental safeguards.

Some may maintain that these provisions are unnecessary to increase domestic refinery capacity because existing regulations are not to blame for the relative lack of investment in increased refining capacity. While no single regulatory requirement should be blamed for discouraging investment in the refining sector, it is difficult to seriously maintain that regulatory costs in the aggregate do not effect industry investment decisions at the margin. Insofar as regulations increase the costs of constructing, expanding and/or operating a refining facility, they decrease the attractiveness of such investments as compared to available alternatives and potential investors will demand greater marginal returns before proceeding with such investments. Make no mistake, regulatory costs and permitting delays reduce the profit margins of proposed refinery projects. Thus, while regulatory burdens cannot explain the entirety of investment trends in this sector, there should be little doubt that regulatory costs have an effect on the margin – and the greater the costs and uncertainty involved with existing regulations, the greater that effect will be. It is true that few firms have sought to construct new refineries in the past few decades, but this is not particularly relevant. Insofar as existing permitting requirements and other regulatory hurdles discourage the construction of new facilities, they discourage such investment before the siting and permitting process begins. If it took the Arizona Clean Fuels project a reported five years to obtain air quality permits for a proposed refinery project, few companies will be encouraged to follow their lead.

Even were if it true that existing regulations and permitting requirements, in the aggregate, have little effect on industry decisions to construct or expand refineries in the United States, there is nothing to fear from S. 1772. If streamlining the permitting process for new refineries does not increase the attractiveness of such investments, then the law’s permitting provisions will not be invoked, as no governor will seek a refinery permitting agreement if there is no interest in expanding or constructing a refinery. In short, while reasonable people may disagree on the extent to which Title II of S. 1772 will spur additional investment in refining capacity, adoption of such a measure is unlikely to cause any harm. The same cannot be said for many competing policy proposals.

Streamlining permitting for new refinery capacity makes sense, but the problems faced by refineries are even larger. Indeed, I would suggest that these provisions do not go far enough. It is well known that many existing regulations impose substantial costs without producing corresponding environmental benefits. In particular, various studies, including the EPA’s noted Yorktown study, have demonstrated that it is possible to meet or exceed current standards of environmental performance at substantially lower cost. During the Clinton Administration, the EPA launched several initiatives, including Project XL, that sought to improve the performance and reduce the cost of environmental programs simultaneously. These initiatives failed to produce substantial benefits because the EPA and state agencies implementing federal programs pursuant to delegated authority under the various environmental laws lack the statutory to authorize deviations from existing requirements, even where such deviations will reduce the cost of meeting or exceeding existing environmental standards. For this reason, the Committee should consider authorizing EPA to waive applicable environmental requirements upon a demonstration that equivalent or greater environmental benefits can be achieved at lower cost. This could further reduce the regulatory costs associated with constructing or expanding refineries to serve domestic markets, while also spurring innovation in emissions control, regulatory implementation and design.

Boutique Fuel Provisions

Gasoline markets’ ability to respond to supply disruptions and price changes have been severely hampered by federal fuel content mandates under the Clean Air Act. Imposing various boutique fuel mandates on different regions of the country has balkanized domestic gasoline markets and increased prices for consumers for minimal environmental benefit. By segmenting national gasoline markets, these requirements have made some regions more vulnerable to supply disruptions and volatile gasoline prices. Some boutique fuel requirements have further strained gasoline supplies by reducing the volume of saleable product that can be produced. Yet since passage of the 1990 Clean Air Act, such mandates have been expanded, not reduced. This is ironic because one of the primary reasons for federal, as opposed to state, regulation of fuel content is to take advantage of the economies of scale inherent in producing a fungible commodity for national markets. Because federal laws have facilitated, and even mandated, the proliferation of various boutique fuels, they have contributed to some of the ills that federal fuel regulation was intended to solve.

Insofar as S. 1772 slows the proliferation of additional fuel mandates, it is a welcome step. Under these provisions, states will continue to benefit from the use of such fuels, but the aggregate number of fuel formulas that refiners are required to produce – and therefore the extent to which national gasoline markets are further fragmented – will not increase as the nation seeks to reduce the amount of air pollution from automobiles.

The Energy Policy Act allows states to seek emergency waivers from federal boutique fuel requirements. S. 1772 sensibly reinforces these provisions by making clear that states will be held harmless under the Clean Air Act where the EPA has granted an emergency waiver. This removes a potential disincentive to states that would otherwise seek waivers under the newly adopted Energy Policy Act waiver provisions. This is a welcome step, but the Committee may wish to consider expanding the opportunities for states to seek waivers from existing boutique fuel requirements where such waivers are consistent with meeting relevant environmental standards. For instance, the Committee should consider granting the EPA broader authority to approve waivers from existing boutique fuel requirements when a state can demonstrate it will attain relevant air quality standards without such fuel mandates. From an environmental standpoint, it is more important that a state meet existing air quality standards than that state adopts specific regulatory controls. If states can meet existing environmental standards without adopting additional fuel content requirements, they should be allowed to do so.

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Federal interventions in energy markets always have the potential to do harm as well as good. Sometimes the net impact is negative. Given some of the troubling proposals recently advanced to address concerns about increased gasoline prices, this Committee is to be commended for its prudent approach to this important issue. It is far wiser to adopt modest measures designed to facilitate the market’s natural response to supply disruptions and price increases than to adopt additional layers of regulatory mandates. Indeed, some proposals, such as those purportedly designed to prevent “price gouging,” could exacerbate the harms that they seek to prevent because the profit motive plays a key role in calibrating supply and demand. As the Federal Trade Commission noted in its June 2005 study, Gasoline Price Changes: The Dynamic of Supply, Demand, and Competition:

Profits play necessary and important roles in a well-functioning market economy. . . Profits compensate owners of capital for the use of the funds they have invested in a firm. Profits also compensate firms for taking risks, such as the risks in the oil industry that war or terrorism may destroy crude production assets or that new environmental requirements may require substantial new refinery capital investments.

Therefore, even the best-intentioned regulatory initiatives to constrain profit-seeking, such as by defining what constitutes a “fair” or “reasonable” profit in a given industry, are more likely to produce future shortages and higher prices than the status quo.

Other proposals would needlessly centralize the regulation of local land use decisions under the guise of facilitating increases in refinery capacity. Such measures would be equally unwise, and would likely undermine the protection of environmental resources at the state and local level. These measures, too, should be rejected.

Mr. Chairman and members of this committee, I recognize the importance of these issues to you and your constituents, and I commend your efforts to develop a sound policy response to these concerns. I hope that my perspective has been helpful to you, and will seek to answer any additional you might have. Thank you.